Opinion: Energy stock prices may soon catch up with crude oil

Companies that improve fiscal discipline are being rewarded by investors, who are reacting positively to evidence that the oil sector can improve returns relative to other sectors.

By

AneetChachra

It stands to reason that, if the product you’re producing goes up in price, all other things being equal, you’ll make more money, which is good for your stock.

I mean, it’s obvious, right?

Unless it happens to be 2017 and you happen to be in the U.S. oil business.

The S&P 500 Index
SPX, -0.07%
has been on a fairly predictable and constant upward path this year, advancing 15%. But during that time, the exploration and production sector has declined by more than 17%. This performance is puzzling when set against the price of Brent crude
UK:LCOF8,
which closed above $60 a barrel on Oct. 27 for the first time since July 3, 2015.

The disconnect is further highlighted by the performance of the S&P Oil and Gas Exploration and Production Select Industry index, which is trading at about the same level it did in April 2016 when West Texas Intermediate crude
US:CLZ7
was below $40 a barrel. However, WTI oil has climbed about 40% since then.

Energy headwinds

A number of factors may have combined to depress interest in oil stocks this year. Legendary oil trader Andy Hall announced he would liquidate his flagship Astenbeck Master Commodities Fund II after it lost almost 30% through June, Bloomberg reported Aug. 3. Other funds are also closing or shrinking, with the First Trust Energy AlphaDEX Fund
FXN, +1.09%
losing more than $1 billion in assets this year. Tax-loss selling is another likely contributor, given the oil sector’s underperformance relative to gains nearly everywhere else.

At a macro level, investors are concerned that an agreement reached in January by OPEC nations and producers from outside the cartel such as Russia to cut production by 1.8 million barrels a day to bring supply and consumption into balance wouldn’t be extended beyond the end of March.

That may change after Russian President Vladimir Putin said in early October that he favored extending the accord to drain the oil glut until at least the end of 2018, a sentiment echoed by Saudi Crown Prince Mohammed bin Salman in a subsequent interview with Bloomberg.

Should the deal be extended at a November meeting of oil ministers in Vienna, it would remove a potential negative catalyst for crude prices and help to encourage investors that oil can remain above $50 a barrel for a sustained period.

U.S. shale’s role

Investors have also been pushing U.S. shale drillers not to kill the golden goose by ramping up rig counts to chase production and reserves, and instead return improving cash flow to shareholders through increased dividends and share buybacks.

Some large-cap oil producers seem to be listening and are beginning to benefit. Shares in Anadarko Petroleum Corp.
US:APC
advanced 8% on Sept. 21 after it announced it will use some of its $6 billion in cash to fund a $2.5 billion buyback through the end of 2018, which amounts to one in 10 of the Texas-based explorer’s outstanding shares at current prices.

Two others that have said they will limit spending on major new projects are Canadian exploration and production companies Suncor Energy Inc.
SU, -0.88%
and Canadian Natural Resources Ltd.
CNQ, -0.04%,
while Cabot Oil & Gas Corp.
COG, +0.86%,
which is more centered on natural gas than oil, climbed 8% Oct. 27 after saying in its third-quarter results that spending would not exceed cash flow.

Such moves have helped crimp this year’s share price declines, with Anadarko advancing 20% since the end of August, Suncor climbing 20% since July 10, Canadian Natural ahead 23% since June 15 and Cabot up 19% this year. Other large-caps are also recovering after early year slumps, including EOG Resources Inc.
EOG, -0.36%
and Pioneer Natural Resources Co.
PXD, +3.90%,
which are up 18% and 15%, respectively, since the end of August.

It seems clear that companies that undertake to improve fiscal discipline are being rewarded by investors who are reacting positively to evidence that the oil sector can improve returns relative to other sectors.

Small-cap companies

While companies such as Anadarko, EOG and Pioneer may be more resilient to a drop in the price of crude because of their size and the lower production costs of their assets, small-caps that are higher on the cost curve due to the location of their drilling rights, such as Denbury Resources Inc.
DNR, -5.43%,
California Resources Corp.
CRC, +0.17%
and Whiting Petroleum Corp.
WLL, +0.67%
could benefit if the price of oil stays around current levels or climbs further for a sustained period, as investors become more confident of the crude market’s stability.

Whichever route investors take — be it on fundamental analysis of large-cap names or via a call on crude prices by looking at more volatile small-cap companies with higher production costs — the disconnect between crude oil and the stock performance of the companies that get the stuff out of the ground may close further in coming months.

Company

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